Intrinsic Value of a Stock: What It Is and How To Calculate It

When investors assess stocks, they often look beyond the market price to determine a company’s true worth, known as its intrinsic value. It represents the fundamental value of a stock based on the company’s underlying business characteristics—its fundamentals—rather than market sentiment or speculation.

Value investors (the most famous is Warren Buffett) use intrinsic value as their compass, seeking prospects where a stock’s market price falls below what they calculate to be its actual worth. By focusing on objective measures rather than market hype or momentum, these investors aim to find undervalued stocks and other assets that others might miss.

Below, we take you through how successful traders calculate intrinsic value—methods that are straightforward and accessible.

Key Takeaways

• Intrinsic value measures a company’s share price worth based on objective, fundamental factors like cash flow, assets, and earnings rather than market sentiment.
• A stock may present a buying prospect if its market price falls below its intrinsic value or a selling opportunity when it trades above it.
• Financial analysts use several proven methods to calculate intrinsic value, including dividend discount models, discounted cash flow analysis, and residual income approaches.
• The accuracy of intrinsic value calculations depends heavily on the quality of data and assumptions you use.
• While not a guarantee of investment success, understanding intrinsic value helps investors make more informed decisions based on the fundamentals of a business.

What Is the Intrinsic Value of a Stock?

Two fundamental questions have divided investors for generations: Can you determine a stock’s “true” value? And if you can, does it even matter for prices in the market?

Value investors believe every stock has an intrinsic value—a fundamental worth that can be calculated by analyzing the company’s business, financial metrics, and future prospects. This approach stands in stark contrast to other investment philosophies:

• Technical analysts argue that a company’s fundamentals are already reflected (or ignored) in its stock price and that future price movements are best predicted by analyzing charts and trading patterns.
• Momentum investors follow price trends and market sentiment, buying stocks that are trending upward, regardless of their underlying value.
• Efficient market theorists maintain that stock prices already reflect all available information, making it almost impossible to consistently identify undervalued or overvalued stocks.

Value investors, however, see the market as often driven by fear, greed, and other human emotions that can cause stock prices to diverge from their fundamental worth. By calculating intrinsic value, these investors aim to identify prospects where market prices don’t reflect a company’s true value, allowing them to buy undervalued stocks or sell overvalued ones.

Investors can use various measures that help determine the intrinsic value of a stock:

• Free cash flow: Free cash flow represents the cash left over after a company has covered its operating expenses and significant investments, known as capital expenditures. These include purchasing assets like equipment or improving facilities such as manufacturing plants. When a company generates free cash flow, it has the resources to reinvest in its growth, cut its debt, distribute dividends to shareholders, or buy back shares.
• Price-to-book (P/B) ratio: This measures the value of a company’s assets and compares them with the stock price. When the price is lower than the value of the assets, the stock is generally undervalued.
• Price-to-earnings (P/E): This shows the company’s earnings to determine if the stock price is reflecting its earnings record or is undervalued.

Models for Calculating Intrinsic Value

Beyond these metrics, which you can find in most stock listings, analysts have developed several models to get the intrinsic value of a stock. Each approach attempts to capture different aspects of a company’s fundamental worth, but they all share one common thread: cash is king. Whether through dividends, earnings, or free cash flow, a company’s ability to generate cash ultimately determines its intrinsic value.

Discounted Cash Flow Models: Following the Money

The most common valuation method used to find a stock’s fundamental value is the discounted cash flow (DCF) analysis. Many analysts prefer it because it focuses on what many consider the truest measure of a company’s value creation: free cash flow. This approach looks at a company’s ability to generate cash after accounting for all operating expenses and investments needed to maintain and grow the business. Here is the formula:

​DCF=(1+r)1CF1​​+(1+r)2CF2​​+(1+r)3CF3​​+⋯(1+r)nCFn​​where:CFn​=Cash flows in period nd=​ Discount rate, Weighted Average Cost of Capital (WACC)​​

As you can see, DCF does the following:

• Excludes noncash expenses like depreciation
• Includes capital expenditures for equipment and assets
• Accounts for changes in working capital
• Represents the actual cash available to investors

Here is why this approach is so widespread:

1. It works for any company generating cash flow, whether they pay dividends or not.
2. It captures the actual cash-generating power of the business.
3. DCF reflects both operations and future growth investments.
4. It accounts for the time value of money through the discount rate.

The main challenge with DCF analysis lies in forecasting future cash flows and determining a realistic discount rate.

Dividend Discount Models

The dividend discount model (DDM) is one of the oldest and most straightforward approaches to calculating intrinsic value—there are online calculators to do the work for you. It cuts through the noise: a stock’s value today equals the sum of all future dividend payments, discounted back to present value. This simply reflects a fundamental principle of value investing—that any asset is worth the cash it can generate for its owners.

The basic formula of the DDM is as follows:

​Value of stock=(CCE−DGR)EDPS​where:EDPS=Expected dividend per shareCCE=Cost of capital equityDGR=Dividend growth rate​

This formula incorporates three crucial elements of intrinsic value:

1. Expected future cash flows (from dividends)
2. Risk (reflected in the cost of capital)
3. The potential for growth (captured by the dividend growth rate)

Important

In options contracts, intrinsic value refers to how much they are “in the money.”

Gordon Growth Model

While the basic DDM provides a good foundation, the Gordon growth model (GGM) offers an approach more attuned to the needs of stable, mature companies. The model assumes companies will grow their dividends at a consistent rate indefinitely—a reasonable assumption for well-established blue-chip companies with steady business models. This also tells you the limits of using this formula, which is as follows:

​P=(r−g)D1​​where:P=Present value of stockD1​=Expected dividends one year from the presentR=Required rate of return for equity investorsG=Annual growth rate in dividends in perpetuity​

This model is particularly useful for valuing the following:

• Stable, mature companies with consistent dividend policies
• Companies in regulated industries (like utilities)
• Companies growing in line with the broader economy
• Market indexes over long periods

For the GGM, you’ll want to stick with companies at or below the broader economic growth rate. For high-growth or early-stage firms with variable dividends, other valuation methods work better.

Residual Income Models

While dividend-based models work well for companies that pay regular dividends, what about companies that reinvest most of their earnings or pay no dividends at all? This is where residual income models come in. These models focus on a company’s ability to generate earnings above and beyond its cost of equity capital (the funds a company raises from shareholders)—i.e., profits. The residual income formula is as follows:

​V0​=BV0​+∑(1+r)tRIt​​where:BV0​=Current book value of the company’s equityRIt​=Residual income of a company at time period tr=Cost of equity​

Here, too, there are online calculators to help. This model offers several advantages:

1. It works for companies that don’t pay dividends.
2. It considers the cost of capital.
3. It recognizes that investors expect returns beyond just getting back their initial investment.

Pulling these ideas together, residual income thus represents the economic value a company creates above its required return on equity. For example, if a company has $100 million in equity capital and a 10% cost of equity, it needs to earn $10 million to cover its cost of capital. Any earnings beyond that represent residual income—true value creation for shareholders.

“Cost of Equity”

The cost of equity is the rate of return a company must offer investors to compensate them for the risk of investing in its stock, reflecting the expected returns that shareholders require for their investment. It’s often estimated using models like the capital asset pricing model.

Why Intrinsic Value Matters

Understanding intrinsic value isn’t just a philosophical exercise—”What is a company’s value, anyway? Is it the market price? Something else?”—it’s a practical tool for making better investment decisions. By comparing a stock’s calculated intrinsic value with its market price, investors can identify investment prospects and, just as importantly, avoid overvalued stocks.

Margin of Safety

Savvy investors don’t buy a stock just because it seems slightly undervalued. Instead, they look for what Benjamin Graham, the father of value investing, called a “margin of safety”—a significant discount to intrinsic value.

For example, let’s say you’re looking at a stock with the following:

• Calculated intrinsic value: $50 per share
• Desired margin of safety: 25%
• Target purchase price: $37.50 or lower

This margin of safety does the following for investors:

• Accounts for potential errors in assumptions or calculations
• Provides a cushion against unexpected market downturns
• Offers greater potential upside if calculations prove accurate
• Reduces the risk of permanent capital loss

Example

Consider a company trading at $40 per share. After conducting a thorough DCF analysis, you estimate its intrinsic value at $60 per share. This suggests a potential upside of $20 (50% over the current share price of $40). However, recognizing that your calculations involve assumptions about future growth and market conditions, you might apply a 20% margin of safety to your intrinsic value estimate:

• Intrinsic value: $60
• Margin of safety (20%): $12
• Maximum purchase price: $48

Even if your intrinsic value estimate proves optimistic, the margin of safety protects you against moderate calculation errors while still offering attractive potential returns.

This systematic approach to valuation also helps you with the following:

• Decide on investments based on fundamentals rather than emotions or market hype
• Avoid overpaying for stocks
• Protect against downside risks
• Maintain discipline in volatile markets

How Is Weighted Average Cost of Capital (WACC) Calculated?

WACC is a financial metric that calculates a company’s overall cost of capital, blending the costs of both debt and equity based on their proportion in the company’s capital structure. It represents the minimum return a business must earn to satisfy its investors and creditors. The basic formula is as follows:

WACC = (E/V × Re) + (D/V × Rd × (1-T))

Where:

• E = Market value of equity
• D = Market value of debt
• V = Total market value (E + D)
• Re = Cost of equity
• Rd = Cost of debt
• T = Corporate tax rate

What Factors Can Cause a Company’s Intrinsic Value to Change Over Time?

A company’s intrinsic value constantly changes in response to internal and external factors. Internally, management decisions about capital allocation, shifts in operational efficiency, and changes in profit margins can significantly impact value. External factors include changes in market conditions, competition, and regulations.

What’s the Difference Between Market Value and Intrinsic Value?

Market value is the stock price of a company. It’s primarily based on supply and demand but can fluctuate due to many factors. Intrinsic value is a company’s true value. It can be thought of as the actual worth of a company when taking the value of its assets and liabilities into consideration.

Is There a Way To Include the Value of What Warren Buffett Calls “Moats”?

When valuing companies for economic moats—sustainable competitive advantages—analysts adjust their models to reflect these advantages. A strong economic moat typically lets a company maintain higher profitability over longer periods than others. This translates into valuation models through several mechanisms: analysts might extend the high-growth period or apply lower discount rates to reflect reduced business risk.

For instance, a company with strong network effects or high switching costs might warrant a longer period of above-market growth rates in a DCF model, reflecting how its competitive position is expected to persist.

The Bottom Line

While calculating intrinsic value isn’t an exact science, it provides a systematic way to make investment decisions using fundamental analysis. Value investors use these calculations not to predict future price gains but to identify companies whose market price has diverged significantly from the value of its business.

Successful value investors typically combine more than one valuation method to cross-check their estimates, stay conservative about their growth and other assumptions, maintain a margin of safety, and update their valuations when they get new information.